Keep Your Eyes on the Size:
Fund Manager Capacity
and Why it Matters
MARCH 2013
“There has been a considerable amount of non-sense written on this
topic. I believe that every professional investor knows that it is an
ironclad law that size reduces outperformance, but I also understand
the investment guild’s vested financial interest in muddying the water.”
- Jeremy Grantham, Chairman, GMO
by David Scobie, Principal
Potential
misalignment of
interests
Introduction
Is a larger size parcel of shares more difficult to
efficiently transact than a smaller trade? If we can
safely assume that the answer to this question is “yes”,
even if only in some cases, then we have the basis for
passing a critical eye over the size of assets managed
by equity managers.
The issue of capacity is one of the more vexing ones
facing the investment industry and also one of the most
difficult for investors to come to grips with. Influencing
this situation is the fact that:
•• Larger managers have an incentive to downplay
the issue, and will avoid at all costs an
acknowledgement that the performance
generated for existing (or potential) clients may
be compromised;
•• The smallest managers – those who are not near a
point where capacity may be a problem – have an
incentive to over-emphasise the issue as a means
of marketing a comparative advantage;
•• Determining a trigger point where the size of assets
is excessive is far from an exact science and is
unique to individual firms in different markets.
Further, often only the portfolio managers
themselves are in a favourable position to estimate
the full costs. In this sense, what is difficult to
measure is difficult to manage (and monitor).
The primary purpose of this paper is to highlight that,
for the assessment of equity strategies, the level of
funds under management (FUM) is an important factor
to consider. A small level of FUM is no panacea for
successful investment outcomes. However, increasing
asset size does bring with it the risk of detrimental
effects on performance.
Many of the more established, and indeed successful
(at least historically), equity managers now have FUM
at levels which have reduced their trading flexibility
and, in some cases, caused them to invest in higher
capitalisation stocks than they might otherwise. This
does not necessarily define them as “bad managers”,
but it does accentuate issues relating to manager/
client alignment.
To state the obvious, businesses generally pursue
profit. For an asset management company, which bases
revenues as a percentage of FUM, the pursuit of growth
is particularly tempting. This is because the marginal
cost of managing an extra dollar is small once a critical
threshold has been reached.
The exercise of “asset gathering” is not necessarily in
the best interest of the client, however, and may run
contrary to the portfolio managers’ objectives of
obtaining the best returns for clients. While a
generalisation, this conflict tends to be most evident in
large, multi-national organisations where we see less
evidence of resolute caps on capacity. The reasons for
this are open to conjecture. However, in our
experience, most stringent management of capacity
tends to exist in firms where there is an absence of
controlling external shareholders, where management
is relatively connected to the day-to-day investment
function, and where the firm is a niche operator.1
1
These circumstances tend to apply to so-called “boutique” firms. However, such status alone in no way ensures conservative capacity management or
superior performance. Further discussion on the merits of boutique managers is contained in “Riders on the Storm – Re-examining the Case for Boutique
Managers”, Mercer, July 2009.
2
Keep Your Eyes on the Size: Fund Manager Capacity and Why it Matters
Whatever the organisational context, we regard it
as highly desirable for firms to put staff incentive
structures in place which have fund performance
outcomes as the dominant success measure (as
opposed to focusing on asset or revenue growth).
Liquidity and the
realities of trading
stocks
Amplifying the capacity conundrum is that, in Mercer’s
experience, quite often the managers who have
surpassed reasonable capacity levels have difficulty
coming to grips with the issue. This is because the
implications of a firm acknowledging that it has allowed
assets to build up to an excessive level are seriously
adverse from the manager’s perspective.
The liquidity of a security refers to how readily it can
be bought or sold. It is implied by factors such as the
security’s market trading volume, bid/ask spread,
number of shareholders and diversification of the
shareholders. It is worth noting that the average
trading volume of a stock on an exchange may disguise
its true liquidity. Many stocks tend towards a low
median trading volume but with a higher average
distorted by occasional large trades.
2
“Size is the enemy of
(fund manager) performance.
If you limit assets under
management, you have
a much better chance
of beating the market.
But asset gathering improves
profits. So what happens? Almost
invariably, managers are out there
gathering assets, trying to
increase profits, and
it comes at the expense
of generating investment returns”
The ability of a fund manager to trade effectively
depends upon the size of active positions held compared
to the liquidity of the market. In simple terms, should the
number of shares scheduled to be traded exceed the
available liquidity of the market, completion of the
transaction will likely take more time and may not be as
efficient. Too much money chasing too few shares drives
the price up. Similarly, immoderate selling over a
confined timeframe creates a surplus of sell orders in the
market place with consequential downward pressure on
market prices (an especially troublesome scenario when
a manager’s stock positions are well known in the
marketplace).3 Both these outcomes are undesirable
from a portfolio perspective.
– David Swensen, CIO, Yale Endowment Fund
2
A more extensive discussion of this topic is contained in “Lost in Transition? Factoring in Costs Before Switching Managers”, Mercer, July 2011.
3
This is a particular hazard where a firm suffers a widespread loss of investor support for any reason and is obliged to liquidate market positions within
a relatively short space of time.
3
Keep Your Eyes on the Size: Fund Manager Capacity and Why it Matters
Transaction costs
It is important to recognise that transaction costs in equity markets are made up of both “visible” cost elements
that are relatively simple to observe and measure, and “invisible” cost elements that are a lot less so.
“Invisible” costs
There are less transparent transaction costs that also need
to be considered:
“Visible” costs
The most transparent cost elements include:
•• The levy paid to market operators to undertake the
•• Market impact. As referred to above, sometimes a price
trade, i.e. brokerage;
adjustment is necessary to accommodate a trade. This
•• Taxes on share transactions, particularly stamp
is reflected in the actual movement of the share price
duty in some countries such as the UK;
relative to the broader market until the intended orders
•• The bid/offer spread, i.e. the difference between
have been filled or withdrawn;
the price at which a broker will buy and sell a stock.
•
•
Opportunity cost of not trading. Due to market impact,
This spread will be tightest for relatively small
in some cases a trade may be not be completed if it
trades in large and liquid stocks. For smaller and
becomes apparent to the fund manager that the cost
medium-sized companies, bid/offer spreads
of doing so would be inordinate. In other cases the
become a more important element of the total cost.
manager won’t even attempt to initiate the trade as they
In some countries, a material proportion of dealing is
know that there will not be enough liquidity in the market
done on a net basis (that is, with no commission) with
to accommodate it; i.e. they have investment ideas they
the broker acting as a principal and seeking to make a
cannot implement. This is a critical factor as a strategy
profit on unwinding the position taken on at favourable
grows in size and one that is challenging for clients
prices. This margin is effectively manifested in a wider
to test.
buy/sell spread. Some larger managers can use their
•• A related occurrence, sometimes known as “alpha
influence in the market to deal almost exclusively on a
decay”, refers to the fact that some value-adding ideas
net basis, thereby bringing down their direct
are particularly time-sensitive. The days taken to
transaction costs. They may also use their scale of
“massage” the required trade through the market may
trading or lack of need for external research to
mean the profit opportunity is lost.
negotiate lower commission rates. These are areas
In the above cases, a lack of adequate liquidity would be
where larger managers may be able to use their size
constraining the scope for a manager with good investment
to advantage relative to smaller managers.
ideas to convert them into added value.
“Invisible” transaction costs can reasonably be expected to
increase as FUM increase, and in many cases will be much
larger than the “visible” transaction costs. Unfortunately they
are also very difficult to identify and quantify, especially to
external parties (including clients and researchers).
“Leakage” in the Investment Process
Steps:
Research and
analysis.
Portfolio
construction
and risk issues.
Notional optimal
portfolio
(excludes any
expected
trading
constraints).
Actual model
portfolio (takes
into account
expected
trading
constraints).
“Visible” Costs:
“Invisible” Costs:
4
Broker
fees,
stamp
duty
Trades
avoided
Actual portfolio
determining
investor returns.
Trade
Execution
Bid/offer
spread
Impact on
Market
Price
Keep Your Eyes on the Size: Fund Manager Capacity and Why it Matters
ANALYSING LIQUIDITY
Some managers, and some relatively simplistic
transaction cost measurement services offered by
custodians, aim to monitor indirect costs across their
dealing desks. They do this through reference to the
average price at which buy or sell transactions are
executed against the volume-weighted average prices
(known as VWAP) of the relevant stocks for the day on
which the trade is executed. This type of measure does,
however, understate indirect transaction costs for buy
and sell orders filled over a number of days, and does
not make any attempt to capture the opportunity cost
element. Specialist third-party firms also exist which
aim to be more sophisticated in measuring transaction
costs, including attempting to measure the impact over
a number of days by monitoring the stock price before
and after a purchase or sale.4
One way in which Mercer considers liquidity is through
holdings-based analysis; in particular, with reference to
the time it would, in theory, take a fund manager to
“trade back to cash” (liquidate the entire portfolio) or
to “trade back to benchmark” (neutralise active
positions). We do this by assigning an applicable
portfolio size for a manager and presuming an ability
to trade a certain proportion (say 20%) of each share’s
daily market volume.
As an example, the chart below for a particular fund
manager shows that, on the basis described, it would
take over 5 days for 90% of the portfolio to be traded
back to benchmark. This only gives a broad indication
of portfolio liquidity as it does not account for potential
placement of block trades – “off-exchange” transactions
can be a meaningful way of deriving liquidity. However,
it is a useful measure of comparison for the same
manager over different points in time, or against
different managers operating in the same sector. The
analysis also identifies particularly illiquid securities in
the portfolio which may be hardest to sell down, and
those benchmark stocks not held in the portfolio which
would be most difficult to acquire.
Liquidity Analysis
100
90
Positions Eliminated %
80
70
Trade to cash
60
Trade to benchmark
50
40
30
20
10
0
<0.1
<0.2
<0.3
<0.4
<0.5
<1
<2
<3
<4
<5
<10
Days
Impacting on the degree of market liquidity in recent years has been some contraction of the conventional “sellside”, i.e. investment houses involved in the promotion, analysis and sale of securities (commonly referred to as
brokers). The market-making services of these intermediaries, which help provide liquidity in markets, are not as
prominent as has been the case historically.
4
5
Sentinel – a division of Mercer – is one such provider of independent transaction analysis.
Keep Your Eyes on the Size: Fund Manager Capacity and Why it Matters
Swimming in dark pools
A notable development in the global trading environment over the past
decade is the use of “dark pools” by institutional investors. Dark pools are
trading venues in which orders can be placed without making them visible
to the market. The trades are usually reported to the exchange after orders
have been executed. Varying views exist as to whether dark pools actually
provide a net benefit to market liquidity. Proponents argue that being able
to buy or sell large blocks of securities without “showing your hand” to
others avoids market impact as neither the size of the trade nor the identity
are revealed until the trade is filled. However, dark pools have been
criticised for their lack of transparency and because the inevitable
fragmentation of trading could lead to less efficient pricing in traditional
open stock exchanges.
The point of low return factors impacting on
capacity levels
A generalisation as to an exact dollar number, or percentage of available
market capitalisation, before portfolio performance is impeded by asset size
does not exist. This is due to the fact that investment managers have different
approaches to generating outperformance and invest in varying sectors and
regions. However, what we can say is that the extent to which the
implementation of an investment process is compromised by high levels of
assets will be influenced by:
•• The level of stock turnover generated by the process, with higher
turnover trading-oriented processes being more sensitive to FUM.
This may also apply when the fund is liable to trade in and out of cash;
•• The market capitalisation bias of the mandate, with strategies focused
on smaller cap (often less liquid) stocks being more sensitive to FUM;
•• The style of the process, with growth styles incorporating a bias to
momentum being more sensitive to FUM than value or contrarian
styles. Value managers argue that they look for stocks that are out of
favour and have relatively abundant supply, with the expectation that
they can exit painlessly when the value is recognised and new buyers
emerge. In that sense they are “liquidity providers”. Conversely, growth
oriented managers tend to acquire “in demand” stocks. They may be
more subject to momentum factors and exacerbate market impact
through their trading strategies;
5
6
6
•• The stock universe, with narrow
or restrictive mandates giving
managers less lee-way to
allocate the FUM;5
•• The level of stock concentration
in the portfolio. Where the
intention is to operate a “high
conviction” strategy with a
limited number of securities, this
will tend to use up FUM capacity
to a greater degree6; and
•• Dealing capability, with
unsophisticated execution
techniques curbing the
manager’s capacity earlier than
might otherwise have been the
case. Managers exhibit varying
efforts in monitoring and
minimising their market
impact. Those managers
wanting to reduce their trading
impact may make use of a
dedicated centralised dealing
team, basket trades, electronic
crossing networks or patient
trading disciplines.
The lifecycle of the strategy is a
contextual factor. Firms that are in
their early stages, with low FUM but
growing, are in a position to
rebalance the portfolio using cash
inflows. This keeps their security
turnover, and hence trading impact,
artificially low. This feature is lost as
growth of the firm plateaus.
Expanding the mandate universe will serve to lessen liquidity issues but may diffuse the area of focus sought by the client.
This is one reason why high conviction strategies tend to charge a higher investment management fee.
Keep Your Eyes on the Size: Fund Manager Capacity and Why it Matters
Taking it to the limit
– the consequences
of excessive FUM
The following are some possible consequences of a
fund manager operating with excessive FUM:
•• The dilution or sacrifice of best ideas because of
an inability to fully execute at a reasonable price
or timeframe (some ideas are particularly
time sensitive);
•• The manager is forced to lower the portfolio
turnover, i.e. artificially increase the holding period;
•• A change in investment style caused by an inability
to trade positions due to liquidity constraints, e.g.
style drift against, say, growth and momentum;
•• The portfolio will tend to have larger cap bias over
time as small and mid cap stocks fall out of the
investable universe;
•• The portfolio will start to more closely resemble the
index as a greater number of stocks are bought;
•• Increased exposure to already-owned liquid
stocks to maintain style, thus increasing company
specific risk;
•• A potentially higher involuntary cash exposure;
•• Forced trading when liquidity is lacking which is
likely to have an adverse impact on the stock
price. Should client support falter and the manager
start to lose large accounts, a snowball effect can
be created7;
•• If not all client portfolios are able to be replicated
because a firm can’t buy or sell enough of a certain
stock, a loss of homogeneity will occur leading to
potential dispersion in returns; and
•• With large FUM, the potential breadth of the investor
base is such that, unless carefully controlled, key
investment staff might be obliged to spend
excessive time on client relationship activities.
Some managers with excessive FUM have been able to
get away with it for a while during periods when they
have gotten most of their investment decisions right. The
periods when they tend to “pay” for higher FUM are
those when they get it wrong, and what would normally
have been a brief period of moderate underperformance
becomes extended. The tendency is that instead of the
manager getting rid of poor stocks immediately that
realisation is made (as they would have done when they
were smaller), they hang onto the stocks in the hope that
they might somehow turn around, knowing that if they
tried to sell them they would be paying a heavy market
impact penalty. This creates a tremendous opportunity
cost, which doesn’t get picked up by transaction cost
measurement systems.
Not too big but not
too small
An implication of the discussion so far is that, all things
being equal, a manager may have to become better at
generating good investment ideas (or more clever
about implementing them) to sustain a given level of
outperformance as its volume of FUM grows beyond a
certain tipping point. This can be thought of as a
“handicap” that a larger manager has to give away to a
smaller manager in order to match its performance.
This needs to be weighed up against any perceived
benefits from the broader and more expensive pool of
investment resource that the larger manager can bring
to the table.
A firm with very low FUM is of little use to its clients if it
cannot achieve a critical mass which enables it to
survive as a business. While it is common for a new firm
to go through an initial period of generating losses as it
becomes established, this cannot go on forever – office
costs need to be paid, resourcing needs to be adequate
and staff reasonably incentivised. Where performance
fee structures are prevalent, times of strong portfolio
returns versus benchmark will boost profitability but
the firm also needs to withstand those inevitable
periods where returns are less favourable.
7 As the manager is forced to exit the securities for cash redemption purposes, the increased supply of the securities may depress the stock price and thus
have a negative impact on performance, which could lead to further client departures.
7
Keep Your Eyes on the Size: Fund Manager Capacity and Why it Matters
Part and parcel of a fund manager developing a
sustainable business is having a diversified client base.
In practical terms, this means the firm not being over
reliant on the “hire/fire” decisions of a relatively small
number of investors or having too many similar types of
clients. This is not always readily achievable, particularly
during a firm’s start-up phase or where FUM is modest.
This again points to some pragmatism being
appropriate when considering what levels of FUM are
acceptable. Larger firms can be more readily relied upon
to be in business not just for the next 12 months but for
some years to come.
Some practical
observations
“Unlike many business buyers,
Berkshire has no ‘exit strategy’. We
buy to keep. We do, though, have
an entrance strategy, looking for
businesses that meet our criteria
and are available at a price that will
produce a reasonable return… If
you have a business that fits, give
me a call. Like a teenage girl, I’ll be
waiting by the phone.”
– Warren Buffet, Chairman, Berkshire Hathaway
In Mercer’s experience, smaller managers
understandably often claim that their small size enables
them to be more “nimble” or “flexible” in the market
than larger managers, thereby giving them an
advantage in their quest for outperformance.
Meanwhile larger managers generally agree on two
things: firstly, that volume of assets can hinder
performance if it gets too high and, secondly, that they
are not yet large enough for their performance to be
significantly hindered by this factor.
Lest this paper imply otherwise, there have been many
examples of managers delivering strong returns even
when their FUM are substantial. In some cases the level
of stock-picking skill is such that higher trading costs
can be absorbed while still generating value-added. In
other cases a valid investment philosophy may be
predicated on consciously trading off liquidity for
controlling or substantial stakes in companies owned.
This can bring about the benefits of strong information
flow and degree of influence, and lend itself to an
“activist” stance. It is a longer term approach, however;
typically associated with low turnover. It is best suited to
firms with a strong reputation and a highly diverse and/
or loyal investor base so as to minimise the likelihood of
material unexpected redemptions.
We should also emphasise that it is by no means a rarity
for fund managers to close their equity products to new
business to protect investor interests, or stipulate that
they will cap the level of FUM at a pre-determined level.
In the former case, a subtle but important distinction
can be made between a “soft-close” and a “hard-close”
policy. As typically interpreted, a soft-close means that a
firm will not take on monies from new clients but will
generally accept flows from existing clients. While
sounding positive on the surface, this approach will fail
to meaningfully address a capacity problem where the
scope for flows from existing clients remains material.
A true “hard close” policy places a more stringent
constraint on FUM levels and is one we witness with
less regularity.
Among large cap or all cap managers, the closure point
for a US, UK or Australian domestic equity product is
most commonly set somewhere between 0.5% and 1%
of the market capitalisation of the relevant market. That
said, it is not uncommon for some firms to attempt to
manage 1-1.5% of the market or more. In such cases,
Mercer’s general approach is for the onus of proof to rest
with the fund manager in terms of size not
compromising returns.
It is worth noting that no fund manager can materially
grow its business without providing competitive returns
for clients over the medium term. In that sense there is
8
Keep Your Eyes on the Size: Fund Manager Capacity and Why it Matters
scope for a self-correcting mechanism to kick in – an
alert client base will react by terminating the firm’s
services and the level of FUM will ease off to more
manageable levels.
Finally, it is perhaps unsurprising that we have
occasionally seen investors (and fund managers)
identifying effective capacity management as an
ethical issue, i.e. being seen to be doing the right
thing by the client.
Suggestions for
addressing potential
problems
To address the issue of capacity, institutional investors
can consider the following actions:
•• Recognise that it is very much a rarity for an equity
manager to admit to having too much money
under management. Some will say that capacity is
not an issue for them, and some will say they are
“closing in” on a limit but it has yet to influence
portfolio returns. Typically the managers will sound
convincing, but not all will be accurate;
•• Pro-actively monitor the asset growth of incumbent
managers and be conscious of how this might
affect their fund performance given the expected
investment style and process. Being aware of how
much they manage within the asset class in related
strategies is also important, e.g. holdings in
emerging market- and small cap-dedicated funds
may affect global portfolios, and vice versa;
•• Use measurement tools such as the portfolio’s
“active share” over time to help flag whether the
strategy is increasingly mimicking its benchmark;8
•• Give consideration to the use of performancebased fees as a means of improving the alignment
between the interests of fund manager and client.
While this is not necessarily a full solution, and at
times may entail paying a higher total fee, a welldesigned fee structure will negate managers being
rewarded for index-like performance and
encourage managers to constrain asset growth;
•• Split assets across a range of managers and
styles so as to reduce exposure to specific FUM
capacity issues;
•• Review, and possibly terminate, managers
considered to be facing liquidity concerns (or
managers who refuse to seriously address
potential concerns);
•• Appoint managers who have demonstrated a
commitment to controlled asset growth in the
relevant investment sector.
A suggested approach from a fund manager’s
perspective is:
•• Address the capacity issue head-on as a longerterm business issue. Ignoring growth constraints is
not a strategy. Plan for it before it becomes a reality;
•• Give weight to the views of investment team
members who have the best chance of knowing
whether the level of FUM may be affecting
portfolio performance;
•• As seen as appropriate, decline additional business
and/or limit the annual new cash flow into the
strategy. A soft-close may be implemented as
an initial measure to reserve capacity for
existing clients;
•• In some cases the only proper response is a hardclose. While this is not an easy business decision,
the upside in terms of credibility with clients and
other stakeholders is not to be under-estimated;
•• Because the threshold at which FUM has a
materially negative effect on performance is not
easy to gauge with precision, erring on the side of
conservatism is an appropriate stance when
adopting a policy;
•• In some cases it may be feasible to offer
complementary strategies which do not cannibalise
alpha generation from existing products. For
instance, some firms seek to expand their business
without impinging on value-added by offering
indexed strategies alongside their active business.
Others will employ different, complementary teams
such as an active growth and/or an active value
team which operate independently (the holdings of
8
“Active share” measures the portion of a portfolio’s holdings that deviates from its benchmark index. A reducing figure over time implies that the manager is
taking less active positions.
9
Keep Your Eyes on the Size: Fund Manager Capacity and Why it Matters
the company still have to be aggregated to lodge
substantial shareholder notices). The above said, a
real concern with this option is that offering
alternatives may compromise the manager’s
original investment style that had led to its success
over the years;
•• Recognise that there is only a finite amount of time
that key investment staff can spend on assorted
client servicing requirements or new business
pitches before their core task is compromised;
•• Be cognisant of the scope for changes to the firm’s
culture or dynamics as it grows. For instance, staff
may need to splinter their responsibilities,
re-establish reporting lines and/or be spread across
different floors or geographies. Does this alter the
“secret sauce”? Is it still a tight-knit team?;
•• Finally, ensure that investment staff are focused on
strong performance and that their remuneration is
clearly steered toward that outcome.
10
“We have decided to close
temporarily to all clients in order
that we may further consider the
implications of becoming a midsized asset manager without
prejudicing the outcome of our
deliberations by continued growth
... Our focus should always be on
managing existing funds well, not
on gathering funds. There seems to
be a fundamental tension between
this principle and remaining open.”
– UK-based global equity manager.
Keep Your Eyes on the Size: Fund Manager Capacity and Why it Matters
Closing comments
To summarise, it is inevitable that there are associated costs, some more
readily identifiable than others, with increasing assets under management.
In general, transaction costs will increase in equity portfolios as the level of
assets increase, regardless of the competence of the firm’s traders.
Eventually a point will be reached at which the impact on performance of
the higher transaction costs becomes significant. Direct costs such as taxes
and commissions may not go up (they may even decrease), but indirect
costs such as market impact and opportunity costs of trades not
implemented will increase. There is nothing that managers can do about
this apart from closing to new business well before they reach the point at
which they become affected.
Mercer does not believe that there is a generic “magic number” beyond
which a manager should not grow its FUM. A concentrated portfolio
focused on large cap stocks has different limits to a more diversified
portfolio or one that is focused on smaller capitalisation companies.
Indexed and enhanced index strategies have higher limits. Managers that
employ a number of different portfolio managers or different products with
different investment styles have different limits again. The targeted or
actual level of portfolio turnover also affects the potential constraints lower turnover styles having higher ceilings than more aggressively
managed portfolios.
Mercer considers the volume of FUM as a distinct characteristic when
assessing a fund manager. In doing so, we find that an analytical approach
which encompasses both quantitative and qualitative aspects yields the
most useful information. We look for signs that managers are dealing with
growth in a realistic, transparent and planned manner. In that way, good
quality managers have the best chance of remaining good quality
managers – the prize for keeping their eyes on the size.9
9
Input into the preparation of this paper is acknowledged from the following Mercer colleagues: Deb Clarke, Matt Reckamp, Andy Barber and Philip
Houghton-Brown.
11
Keep Your Eyes on the Size: Fund Manager Capacity and Why it Matters
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